Wednesday, April 4, 2012

Why Stock Market Indexes are making new Highs but not our Portfolio?

If we look at the charts of most Stock Markets in the world, the trend seems to be bullish biased. It is always bullish and will remain so in the future.
 Just look at the following 50 years chart. The Dow had been going up since the 1960s and is still going up because it is always long term bullish biased.

The question is how can the market be so bullish when economic data suggest otherwise?

For example just take a look at America’s problems which include $15 trillion in funded and $135 trillion in unfunded debts, budget deficits of more than $1.3 trillion in 2011 fiscal year, more than 8.5% unemployment rate, 46 million Americans on food stamp,  Debt/GDP had already surpass the 100% mark, 23 million workers are either unemployed or underemployed and the lists can go on and on ad infinitum.

How can the Dow Jones be trading at about 13,200 (03/04/2012 closing) which is only less than 1000 points from the all time high of 14,164 points? And yet most of our portfolios are no where near all time high, in fact most of them are now below last year’s level.

In my earlier article on ‘The Danger of having a Weak Economy and a Strong Stock Market’, I have discuss the issue on market overvaluation and why the need for it. Now I am going to show you how they do it.

I am sure a lot of us are frustrated at why our stocks are not making new highs but in fact a lot of them went below the price that we bought?

Take for example yesterday the Indonesian market, their Composite Index IHSG managed to close at an all time high of 4215 after besting the 4196 level, which is set on 01/08/2011.  The market performance was 124 Up, 120 Unchanged and 202 Down. Since the Composite made an all time high, why are there more down than up counters? Why most stocks did not test their new high? In fact they perform worse than last year. The answer can be found in the following.

  1. Firstly, new stocks are added every year through IPO. At the meantime old stocks that are not performing or went into bankruptcy are delisted from the exchange. There are more new stocks added to the list than being taken out and hence the list of stocks grows every year. The Darwinian Law on survival of the fittest also applies to the stock market. Hence every year bad and poorly performed stocks are taken out of the list and new and healthy ones are added to the list.
If you look back at the records of Dow Jones for the last 100 years, less than 3% of the stocks managed to maintain their original name. For the past 50 years only less than 10% managed to do that. What does this tells us? A lot of the companies did not survive intact throughout the years, many of them either delisted, gone during a Merger, Acquisition or being Takeover exercise. And again along the way many new stocks are added while old ones are pushed out from the list.

This is one of the main reason why the stock market is always going up.

  1. Secondly, the Composite Index is made up of only a handful of Stocks. Like the Dow is made up of 30 stocks, Malaysia's KLCI has 100 and so on. Normally these stocks have large market capitalization and hence also their weightage on the Index. Again it is the same old story, ‘not performing or tired’ stocks are taken out of the group and new ones are added into it. So this can be regarded as cheating and they can do continue doing this as long as the index keep going up.

This is also similar to Hedge Funds when they apply survivorship bias in their reporting. Since they are not under the jurisdiction of the Securities Exchange they are not required to report to them. In other words, they are free to cook their books. Under perform quarterly figures are discarded from their annual reporting and hence their reporting is always better than their actual performance.

So why do they want the market to go up? In my earlier article I mentioned that an overvalued market benefit everyone from the stock brokers to the politicians. Only us suckers got squeezed in the end because when the music stops, we are the ones will be the last to leave the party.

  1. Thirdly, we only have ourselves to be blamed. Due to the propaganda by the market promoters and propagandist from the corporate mainstream media we are more or less afflicted with a disease called ‘Normalcy Bias’.

Normalcy Bias refers to a situation where the mental state of the people failed to estimate the possibility and effects of a disaster that is looming. When facing a stock market crash instead of taking evasive action to cut loss we tend to focus on the unexpected event and enter into a state of paralysis. It is normal for investors to be overwhelmed by losses and hence failed to do the right thing and that is to get out of the market. This is because we are constantly fed with ‘good and soothing’ stories by the mainstream media and condition our mind to accept that things are always in good hands and order. Consider the following quote,

"The man who never looks into a newspaper is better informed than he who reads them; inasmuch as he who knows nothing is nearer to the truth than he whose mind is filled with falsehoods and errors." – Thomas Jefferson

So what lessons do we learn from here? 

One. How can we counter this kind of market manipulation? One way is to imitate what they do. Remember how they frequently tossed out bad stocks and replaced them with good ones? The reason being that the Composite Index will always make up of good and healthy stocks and hence will always go up.

So in order to beat the market we need to do the similar thing and that is to ‘chuck the bad and keep the good ’ stocks in our portfolio. Remember to rebalance our portfolio every 3 months and I can tell you your portfolio will perform much better than what you expected.

Two. Another lesson is that the old Wall Street adage 'Stock are for Long Term' does not hold anymore. With the rate stocks are disappearing from the market (less than 10% survived in 50 years),buying now and giving it to your grandchildren is not a good option anymore. Stock promoters in Wall Street or wherever they are will always tell you that the market is always going up. What they didn't tell you is they always change their rules and issues so that people like us will always be suck into the bottomless pit.

Two weeks before Enron collapse analyst still recommend a buy on the stock. One month before MF Global's collapse, analyst still recommending a 'Hold' on the stock. So how can we protect ourselves from the market? The only solution is market education and form your own judgment. Never trust anybody on investment decisions because 'Herd Instincts and Group Behavior' never work in markets.

Later, I will be addressing the issue on ‘Why using Fundamental and Technical Analysis produce mediocre performance in The New Stock Market?’

No comments: